Educational Articles

Industry Analysis: Biotechnology

Nira Maharaj
| August 07, 2014

The Biotechnology Industry is a highly volatile and unpredictable sector due to the scientifically intensive nature of the operations of companies that reside here. Markets served include medical, agricultural, environmental, and industrial. Biotech firms differ from conventional drug makers in that they utilize natural ingredients, as opposed to synthetic ones.

The Biotechnology Industry is a highly volatile and unpredictable sector due to the scientifically intensive operations of companies that reside here. Markets served include medical, agricultural, environmental, and industrial. This industry emerged in the 1970s, with the main goal of enhancing the quality of human life. Biotech firms differ from conventional drug makers in that they utilize natural ingredients, as opposed to synthetic ones. Drugs are manufactured in a living system, i.e., a microorganism, plant or cell.

On the medical front, the endeavor to improve people's health is fulfilled through the creation of recombinant DNA (deoxyribonucleic acid), which is done by combining DNA sequences that do not naturally intermingle. With these DNA alterations, biotech companies have discovered treatments and therapies for a range of diseases, such as various forms of cancer, AIDS (acquired immune deficiency syndrome), Alzheimer's, and diabetes.

Operators seek to optimize profitability via commercial success, which represents a pinnacle for any biotech company. In order to reach such a position, companies must undertake laborious research. Biotechnology firms are among the most research-intensive organizations in the world. Their product pipelines, a vital component of expansion, are capital intensive.

Established companies typically fund their growth ventures with cash flow, but debt and equity markets are sometimes tapped. Since many biotech companies are small, and cash is often scarce, external funding can be important. Patrons are typically big pharmaceutical companies or investment entities that stand to reap significant rewards from taking a stake in a drug that is commercialized. During difficult economic times, outside funding often dries up, as lenders become budget-constrained and more cautious about investments.

Growth Contingencies

New discoveries for the treatment of diseases provide opportunities for growth and gains in stockholder value. Investors must, however, be willing to tolerate volatile or weak results in the short term. In many instances, a biotech firm may have to endure a lengthy period of sometimes-heavy losses before a drug comes on the market and yields operating benefits. The sales and earnings potential of a newly introduced commercial drug or treatment can be immense and remain positive for years. Indeed, patented biotech drugs enjoy a 12-year period of protection from generic competition, allowing a sustained period of favorable returns.

Biotech drugs are expensive, however, and there is pressure from insurers, governments, and consumers to rein in healthcare costs. Some legislators regularly attempt to increase industry competition. If the period of market exclusivity is ever reduced, research-funding sources likely would be curtailed, and there would be a material, negative impact on long-term sales and profitability. So far, the companies have held on to the prohibition period by successfully arguing that biotech drugs are scientifically complex, not easy to duplicate, and costly to develop. In fact, most prospective drugs never complete clinical trials and reach commercialization, since conclusive scientific evidence of efficacy, in many instances, proves elusive.

Regulatory Considerations

The U.S. Food and Drug Administration (FDA) is the primary regulator of the Biotech Industry. Before a drug makes it to market, it must traverse a strict clearance process set forth by the FDA. Statistically, there are significant odds against a drug progressing through all the required clinical trial stages. For every 5,000 compounds discovered in pre-clinical studies, only about five make it to FDA approved status. There are four stages in the FDA trial process; in the final step, drugs are placed on the market. Even after approved for use, drugs are subject to ongoing studies, in which patients are monitored for negative side effects. Recalls due to injuries and/or fatalities are not uncommon. Patents are nullified in the event of a recall. Companies invest considerable time and resources to ensure a product's success. Recalls not only hurt sales and net income, but they may severely tarnish the reputation of a firm.

In addition to the FDA, other agencies have authority over the industry. Notably, the Environmental Protection Agency and Department of Agriculture hold sway, regarding the marketing of biotech offerings that might have a big effect on the areas under their respective control.

Uses of Cash

Like the majority of companies under our review, biotech firms must determine the best use of cash sourced from operations, as well as from equity and debt issues. First and foremost, the goal is to achieve out-sized growth, and managements work to ensure fully funded research and development budgets. Substantial capital is also spent on gaining approval of new drugs and bringing them to full production. Marketing and distribution require sizablel funds, as well. Acquisitions are more common among large industry players, which, at times, seek to bolster their lineups. In descending order, debt retirements, stock repurchases, and dividends are the least desirable uses of cash.

The nature of the operations of firms in the Biotech Industry makes these equities more suited to aggressive, risk-tolerant investors. Stock prices here can fluctuate dramatically, particularly in response to news developments concerning the success or failure of a particular drug. Investors must carefully consider a stock's risk/reward relationship. Often, investors must be patient and willing to endure years of losses before the benefits of a drug pipeline, in the form of long-term share-price appreciation, are realized.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.